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Michael Pope Blog post by Michael Pope

Another Look at Risk

In previous articles, we have been looking at the inputs to and outcomes from an investment strategy.  We have looked at the way the amount of money, the amount of time and the amount of knowledge that you put into an investment can influence the outcome, and how the use of other people’s time, money and knowledge ( which we referred to as leverage ) can affect the outcome.  We also discussed the desired outcomes from an investment, focussing on the anticipated return that would be received, which is generally some combination of growth and yield.

Another aspect of any investment is the level of risk involved.  In an earlier article we discussed this in the context of the risk of an investment failing to achieve the desired level of return, either in yield or growth.

Another way to consider the investment risk is to look at the variability of the return from year to year.  In this context, an investment which had returns which varied more from one year to the next would generally be considered to be more risky than an investment with a lower variability of return.

One way this is often presented is by quoting the probability of a negative return.

For example, a superannuation fund might offer a range of different investment options, with different investment strategies, and therefore different anticipated returns and different variability of returns.  They may describe these alternative investment options using words like growth, balanced or conservative, where each option has a different objective for the level of return and a different variability of those returns.  And so the growth option may described as having a likelihood of a negative return as “1 year in every 4”, while the balanced option may be stated as “1 year in every 6”, and the conservative option as “1 year in every 8”.

These descriptions are intended to indicate that the growth option has a higher variability of returns than the balanced or conservative options and therefore a higher probability of a negative return.  It doesn’t mean that there will be a negative return once every 4 years, any more than a “100-year flood” is expected to come along exactly once a century.  It is simply a measure of the probability of the outcome, which could actually happen at any time.

 

A simple illustration

To illustrate how risk affects the outcome of an investment, let’s imagine a couple of simple games involving tossing of coins.  In each game it costs $10 to play ( your initial investment ).  The first game uses two coins and, after each toss, you receive $15 for each head that is showing.  There are three possible outcomes  –  two heads will result in you receiving $30 ( a profit of $20 ), one head and one tail will get you $15 ( a profit of $5 ) and two tails mean you will receive nothing ( a loss of your original $10 investment ).

If you were to play this game a number of times, you could expect that your profit ( return ) per game would average out to $5.  But each time you play there is a 25% chance of a loss, and in this case a 25% chance of losing all your money.

The second game is a bit more complicated, involving the tossing of 10 coins at once.  It still costs $10 to play and you receive $3 for each head showing after each toss.  As in the previous game, all heads means you receive $30 ( a profit of $20 ), all tails means that you receive nothing ( a loss of $10 ) and the average profit per game can be expected to be $5.

 

Would you want to play either of these games?

I hope so, because, unlike at a casino, the odds here are in your favour.  Although you should expect to lose money sometimes, for every game you play you can expect to be $5 richer.  But which game would you prefer?  The difference between these games is not in the maximum, minimum or average returns, which are all the same, but in the variability of the returns.

The first game had a 25% chance of a loss ( or 1 in 4 ); in the second game, the chance of a loss ( receiving less than $10 back ) is around 17% ( about 1 in 6 ).  In the first game, there was a 25% chance of receiving nothing ( a loss of $10 ); in the second game, the chance of receiving nothing is a mere 0.1% ( 1 in 1000 ).

In the language of statistics, the expected profit from each game has a mean ( average ) of $5, but the profit from the first game has a Standard Deviation of about $12 while the profit from the second game has a Standard Deviation of about $4.75.

Standard deviation is a statistical measure of variability and is often used to describe the variability of investment returns, which as we have discussed is a key indicator of the level of  investment risk.  The numbers show that while our two games offer the same expected return over time, playing the second game involves a significantly lower variability of returns.

So now which game would you prefer?

It turns out that most people prefer consistency, and so would choose the game ( or the investment ) with the more consistent, or less variable, returns over time.  For a given level of return, most investors are going to choose the investment with the lowest risk.  Conversely, to compensate investors for taking on a investment with a higher level of investment risk, they are typically going to be looking for a higher return.

So in developing an investment strategy and selecting investment assets, getting the correct balance between risk and return is going to have a major impact on the outcome achieved.  This is a critical factor in the success of a long term wealth creation strategy, and one of the reasons why Empower Wealth considers the choice of investment asset to be such an important decision in implementing an investment strategy.

Empower Wealth’s Personal Wealth Management Program includes a sophisticated Wealth Projection Simulator which allows you to see the effect of asset selection decisions by modelling the effect of different returns, together with all the other factors which influence the long term financial outcome of an investment, to give you the numbers you need to make an informed decision about your financial future.

If you would be interested in seei ng how these tools and techniques could be applied to your own personal financial situation, please come and see us for a free one hour consultation.

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